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Department of Accounting and Finance
M.Sc. Finance
International Banking and Capital Markets
Friday 30 th^ May 2008 10.30am – 12.00pm (1 ½ hours)
Instructions for Candidates
Answer THREE Questions
[Failure to comply will result in papers not being marked]
Calculators must not be used to store text and/or formulae nor be capable of communication. Invigilators may require calculators to be reset. All answers are to be written in ink. Please write clearly as illegible writing cannot be marked. Failure to follow these requirements will lead to a deduction of marks.
To Be Completed (please write clearly)
Family Name:
Other Name:
Please Note: This question paper is to be returned along with your
examination answer booklet, you should complete the above and
slip this paper into your answer booklet. Under no circumstances is
a copy of this paper to leave the exam room.
Q1. As the treasurer of a US company you hedge all major future transactions. You are anticipating the receipt of £12,500,000 in March and decide to use currency options to hedge the exposure associated with the transaction. The contract size is £62,500 and the underlying March currency future is $1.792. The following information is available on the market prices for options with difference maturities and strike price.
a) Set up a hedge using the options with a strike price of 1750, making it clear whether you are proposing to use call or put options. Draw the risk profile for the company and add to the diagram the effect of using the currency option. (10 marks)
b) Explain the premium on this option in terms of time value and intrinsic value. (7 marks)
c) Illustrate the cash flows if the spot rate and the futures rate are $1.65/£1 at the maturity of the option in March. (9 marks)
d) Outline a valuation model that can be used to price currency options. (7 1/3 marks) (TOTAL 33 1/3 MARKS)
[Please Turn Over]
Q3. a) Arbitrage is very important in the pricing of currency derivatives. Explain this statement, providing an example. (7 1/3 marks)
b) The following is an extract from the financial press.
POUND SPOT FORWARD AGAINST THE POUND November 19 th Pacific/MiddleEast/Africa
Country Spot Bid/Ask 1-year forward Japan 172.550 456 – 644?
Assume interest rate parity holds.
If one-year interest rates in Japan and the UK are 1/12 per cent and 4 ¼ per cent respectively, what is the one-year Yen forward rate? Is the Yen at a premium or discount? (8 marks)
c) Assume the following information: Spot rate for Euro 1.390/1.395/£ 180 day forward rate for Euro 1.425/1.430/£
180 day Euro interest rate 2.50%/2.55% p.a. 180 day UK interest rate 5.5%/5.55% p.a.
Given this information is covered interest rate arbitrage worthwhile? Show the profit you would earn on a £500 million transaction. (10 marks)
d) You are a speculator and can trade up to £100 million. The current spot rate is $2.01/£ and the one year forward rate is $1.98/£1. You think one year US interest rates may fall below the current level of 3 per cent by 1 per cent. UK interest rates are expected to remain unchanged at 5 per cent. Set up the speculative position using forward contracts. (8 marks) (TOTAL 33 1/3 MARKS)
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Q4. a) What are the main characteristics of currency (foreign exchange) swaps?
(13 marks)
b) Two companies, A and B, borrow at different interest rates in US dollars and pounds sterling, as follows: Dollar Sterling Rate Rate Company A 8% 10% Company B 13% 12%
(Interest rates are quoted as per cent, per annum.)
i. Describe a set of circumstances for which a currency swap would be to the advantage of both companies. ii. Explain how an intermediary could devise a currency swap that would be attractive to both companies and to the intermediary. (13 marks)
c) Describe how speculators may operate in the forward and future currency markets? (6 1/3 marks) (TOTAL 33 1/3 MARKS)
Q5. a) Explain what is meant by the Eurocurrency market, making it clear how it differs from the domestic market. (17 marks)
b) “The origins of the eurocurrency market may be linked to political factors but the subsequent growth of the market is the result of its relative freeedom from regulation”. Discuss (16 1/3 marks) (TOTAL 33 1/3 MARKS)
Q6. a) Explain the difference between the foreign bond market and the Eurobond market.
(17 marks)
b) Explain why companies might prefer to raise funds in the Eurobond market rather than issue bonds in the domestic market. (16 1/3 marks) (TOTAL 33 1/3 MARKS)
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